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Microsoft's New Xbox One Initiative Could Be GameStop's Worst Nightmare

Beginning next month, Microsoft (NASDAQ: MSFT) will offer select Xbox One games at a significant discount -- as much as 50% to 75% off their regular retail price. Xbox One owners looking to take advantage of these sales won't be heading to their local GameStop (NYSE: GME) ; rather, the discounts will only apply to digital copies downloaded directly from Microsoft's online storefront.

Two of the Xbox One's biggest games -- Forza 5 and Ryse -- will kick things off; many more titles will follow. If history is any indication, this could be the beginning of the end for physical Xbox One games, and by extension, the start of GameStop's demise.

History as a guide: The PC marketIn 2007, something funny happened -- sales of retail PC games posted an annual decline. Analysts blamed piracy, the growth of consoles, and a waning interest in the PC platform as a whole, and media outlets declared that PC gaming was dying.

In fact, nothing could've been further from the truth. PC gaming continued to grow (today, PC gaming brings in more revenue than console gaming), but the numbers just didn't show it. In 2010, research firm NPD sampled the market for digital PC games and discovered why -- from 2006 to 2010, the growth of digitally downloaded PC games exploded, to the point where, in 2010, it accounted for more than half of the market.

Those trends have continued. Today, many PC games don't even get retail releases, and few stores still carry boxed copies. Head into your local GameStop and it's unlikely you'll find anything more than a single shelf devoted to PC games.

The rise of SteamWhy did PC games go digital? There are several factors, but nothing more significant than the rise of Valve's Steam.

Steam is to PC gaming what iTunes is to music: Users sign up, create an account, attach a credit card, and begin purchasing digital copies of PC games. Those games then become tied to that user's account, and can be downloaded to several computers, or redownloaded in the event of hard drive failure.

That's convenient, but what really sets Steam apart is its sales -- it offers sharp discounts on its games on a weekly basis, and its semiannual holiday sales are the stuff of Internet legend. The discounts offered are so aggressive (as much as 90% off) that many games are purchased and never played -- according to Arstechnica, 37% of the nearly 800 million PC games that Steam users collectively own have never been played.

Unfortunately, Valve is a private company, making its revenue difficult to ascertain. But analysts have estimated that about 7 in 10 digitally downloaded PC games are purchased through Steam.

Bringing Steam to the XboxMicrosoft's new initiative will bring the equivalent of Steam sales to the Xbox platform. Exact pricing and plans have not been revealed, but in its release, Microsoft mentioned both Forza 5 and Ryse and promised discounts of 50% to 75% off.

If Microsoft offers both games at 75% off, they would retail for just $15. For comparison, GameStop is currently selling used copies of those titles for $45 each. Even if Microsoft only offered them at 50% off, they would still be significantly cheaper ($30).

To continue selling these games, GameStop would be forced to slash its pricing, devastating its margins in the process. As I noted earlier this year, that's exactly what GameStop did with Ryse in response to a short-lived test run Microsoft conducted in February.

But it's even worse than that. In addition to losing out on potential sales, GameStop would have fewer used games to sell. Once purchased, a digital copy becomes locked to an Xbox One owner's account and cannot be resold -- giving GameStop less used-games inventory to move.

Analysts just don't get itGameStop shares actually rallied on Tuesday as analysts misinterpreted Microsoft's intentions. In addition to offering digitally discounted games, Microsoft will begin selling a version of the Xbox One at $399 next month, an incremental positive for GameStop, according to R.W. Baird. But with Microsoft's new plan to aggressively discount digital games, it's likely that fewer new Xbox One owners will buy their games from GameStop in the future.

Given that about half of GameStop's revenue, and 70% of its profit, comes from the sale of disc-based games, Microsoft's announcement on Tuesday is one of the worst things that could've happened to the retailer.

Microsoft's Xbox One is more than just a video game consoleMicrosoft's Xbox One offers owners a variety of entertainment options, giving access to digital content in addition to paid TV. As more consumers turn to cord-cutting, you know cable's going away. But do you know how to profit? There's $2.2 trillion out there to be had. Currently, cable grabs a big piece of it. That won't last. And when cable falters, three companies are poised to benefit. Click here for their names. Hint: They're not Netflix, Google, and Apple.

Comments from our Foolish Readers

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I don't like the idea of them giving their major retailer the shaft, but perhaps game CDs are going the way of the movie DVD, and gamestop will follow blockbuster. I'm not happy about that, I still enjoy single player games, and I still rend movies from red box. But the new generation is more about mobile, clouds, and streaming.

Do you actually get paid to write articles bashing GameStop every week? It's getting really old. I swear you must have had a really bad experience with them once and are just hoping against hope that they'll go belly-up. Ain't happening, buddy boy. Discs for console games will be here to stay for a really long time. Neither the demand nor the infrastructure is there to support a digital-only console. Any console that doesn't support discs will go the way of the PSP Go.

The install base for a console that only does downloads would be too small to support the industry as it exists today. Based on various metrics (broadband penetration, connection quality, subscription rates for online services), they will lose at minimum a third of their customers simply because said customers simply could not buy the system. Of course, this isn't including people who would outright refuse to buy such a system, and who knows how many millions of people that would be. If the best-selling system is pulling only one or two million systems a year, big publishers like EA won't be selling enough games to cover their costs.

In order to move gaming forward, publishers had to invest ever greater sums on development, including better graphics, bigger worlds, smarter AI, more advanced physics, better servers for online play, and so on. If software sales plummet because tens of millions of customers are either unwilling or unable to buy digital-only AAA games (which will still cost full price, have no resale value, and aren't owned by the customer), the studios can't afford to make popular series like Grand Theft Auto, Halo, and Assassin's Creed. Gaming will regress to where it was in the 90s because budgets will drop considerably. We might be lucky to see anything more advanced that what we saw on the N64. Nostalgia aside, nobody really wants to see gaming devolve back to where it was 15-20 years ago.

It's hilarious how clueless video game players are. They're on here clinging to their physical discs because its what they're used to but in our hearts we all know that digital is coming. Go read the NPD reports that talk about how digital sales grow and physical game sales DROP EVERY YOY quarter.

Why don't you people just go short some gamestop shares (like I did) embrace the future and just let it go already.